A detailed explanation of how to budget, types of budgeting, the benefits, and the critiques of the budgeting process.
A detailed explanation of how to budget, types of budgeting, the benefits, and the critiques of the budgeting process.
In the broadest sense, a budget is an allocation of money for some purpose. The word once used to mean "pouch" or "purse"; a budget therefore is "what's in the pouch." Budgeting as an activity ranges in extent from managing household finances on up to the preparation of the Budget of the United States, undertaken yearly by Congress; that document is nearly 1,400 pages in length. This article will focus principally on "formal budgeting" as practiced in corporations, sometimes called the "budget process."
Budgeting has always been part of the activities of any business organization of any size, but formal budgeting in its present form, using modern budgeting disciplines, emerged in the 1950s as the numerical underpinning of corporate planning. Modern corporate planning owes much to operations research and systems theory. A pioneer in that field, Russell L. Ackoff, worked closely with General Electric, Anheuser-Busch, and other major corporations. His first book on the subject, the first of four, A Concept of Corporate Planning, had a major impact.
Modern formal budgets not only limit expenditures; they also predict income, profits, and returns on investment a year ahead. They have evolved into tools of control and are also used as a means of determining such rewards as profit-sharing and bonuses. Unless the budgetary process is managed with extreme skill and care, the very virtues of budgeting can turn into negatives—and have, of late, emerged into a movement actively working to change this process.
BUDGETING AS A PROCESS
In large corporations, budgeting is a collective process in which operating units prepare their plans in conformity with corporate goals published by top management. Each unit plan is intended to contribute to the achievement of the corporate goals. Unit managers prepare projections of sales, operating costs, overhead costs, and capital requirements. They calculate operating profits and returns on the investment they intend to use. The budget itself is the projection of these values for the next calendar or fiscal year. As part of this process, each unit presents its plans and budget to a reviewing upper management panel and may, thereafter, make whatever changes result from instructions from or negotiations with the higher level. Texts presenting, documenting, and defending the rationales underlying the numbers are usually part of the planning document. Approved budgets then become the road-map for operations in the coming year. Ideally monthly or quarterly budget reviews track performance against the budget. As part of such reviews, changes to the budget may be approved. At year-end managers are judged by their performance against the budget.
Many small businesses try to operate without a formal budget. Even some businesses that have a budget seldom consult it, meaning they are not gaining the business advantages that they could be through budgeting. For startup entrepreneurs, a budget is like a roadmap that can help them set goals and assess the validity of their business concept. For established small businesses, a budget can be used to take the pulse of the business, determining how the business is performing through the years, and helping identify possible future investments. By regularly consulting a budget, business leaders can compare actual figures and catch potential business shortfalls or other problems early. Budgets can also be instrumental in winning over investors, convincing banks your business is a good loan risk, or bringing on new partners or customers.
While budgets are developed bottom up, managers must strive to meet top-down business goals (e.g., "Annual growth in after-tax profits of 39 percent."). Because performance is measured based on meeting or exceeding positive projections (of sales, returns, and profits) and meeting or coming in below negative projections (fixed and variable costs and capital expenditures) managers have strong incentives for projecting the lowest possible "positive" and the highest possible "negative" results. The more successful they are in understating sales and profits and overestimating costs, the higher the likelihood of "meeting the budget." Top management's incentives, by contrast, are to do the opposite. Therefore the budgeting process is inherently marked by potential conflict.
Such difficulties can be, and usually are, mitigated by rational policies, good will on both sides, and straight forward implementation. Projections should be as realistic and quantifiable as possible. If projections are out of line with historical patterns, up or down, management must question the planning. Thus, for instance, a sharply rising projection of costs must have some real-world justification. Overly ambitious revenue projections must also be questioned. Conversely, managers must resist pressures sharply to raise revenue targets unless tangible changes in the market or compensating raises in sales expenditures are present. If the negotiating levels are honest and realistic, the right projections will result. Ideally, operating units should not be measured on activities over which they lack full control. An operation which does not operate its own debt collection, for example, should not be measured on how rapidly invoices are collected. Since budgets are often at least 50 percent guess-work, formal budgetary review at reasonable intervals and realistic adjustments based on actual events must be part of a well-functioning process. All too often, the spring budgeting event is rapidly forgotten.
BENEFITS AND COSTS
The single-most potential benefit of formal budgeting lies in ensuring that responsible managers take time each year (and then at fixed intervals throughout the year) in thinking about their operation by looking at all of its aspects. Budgeting creates a comprehensive picture of the future and makes both opportunities and barriers conscious. This foreknowledge then helps guide day-to-day activities.
The chief cost of the budget process is time. In some corporations the process takes on a life of its own and becomes a convoluted exercise of excessive complexity which, moreover, prevents unit managers from doing any thinking: their time is consumed in efforts to comply with a vast array of requirements dictated from above. Much of the negative attitude that has developed concerning this activity has its roots in unnecessary bureaucratic impositions on the one hand and unreliability because of rapid change a few months out.
TYPES OF BUDGETS
The two dominant forms of budgeting are traditional and zero-based. Business planning is usually a combination of the two. Traditional budgeting is based on a review of historical performance and then the projection of such findings to the future with modifications. If inflation is high, for instance, cost trends of the last several years are projected forward but with adjustments both for inflation and for projected growth or decline in business activity. Historical sales patterns, using established trends in sales growth, are projected; new sales from planned new product introductions are then added. Zero-based budgeting is the creation of a completely new budget from the ground up—as if no history existed. When using this method, the operation must justify and document every item of expenditure and income anew. Brand-new operations will utilize zero-based methods.
In government planning, but only very rarely in business, performance budgeting is used as a third alternative. Under this method, the budget is fixed at the outset. The planning activity is to determine exactly what activities will be carried out using the allocated funds. Performance budgeting is sometimes used in the corporate setting when the advertising budget is arbitrarily set as such-and-such a percent to projected sales. The advertising function then uses performance budgeting to allocate the budget to various products and media.
For the small business, different types of budgets can be drafted to monitor various financial aspects of the business.
• Operational budget - An operational budget is the most common type of budget used. It forecasts and tries to pretty closely predict yearly revenue and expenses for a business. This budget can be updated with actual figures on a monthly basis and then you can revise your figures for the year, if needed.
• Cash flow budget - A cash flow budget details the amount of cash you collect and pay out. This is generally tallied on a monthly basis, but some businesses tabulate this weekly. In this budget, you track your sales and other receivables from income sources and contrast those against how much you pay to suppliers and in expenses. A positive cash flow is essential to grow your business.
• Capital budget - The capital budget helps you figure out how much money you need to put in place new equipment or procedures to launch new products or increase production or services. This budget estimates the value of capital purchases you need for your business to grow and increase revenues.
CRITIQUES OF THE PROCESS
As early as 1992, the famous guru of management, Peter Drucker, wrote in The Wall Street Journal: "Uncertainty—in the economy, society, politics—has become so great as to render futile, if not counterproductive, the kind of planning most companies still practice: forecasting based on probabilities."
Uncertainty has, if anything, grown since 1992 with the expansion of the Internet, the reality of terrorism, pressures on hydrocarbon fuels, the threat of global warming, and worldwide epidemics. In addition to uncertainty, formal budgeting has also come under fire for impeding trust and empowerment, two new concepts in the evolving corporate culture, as well as for stifling innovation. As David Marginson and Stuart Ogden recently wrote in Financial Management (UK), "Budgets have long had a bad press, but they have attracted even more flak recently for being at best inappropriate to modern business practice and at worst potentially harmful…. The Beyond Budgeting Round Table (BBRT) has been one of their most vociferous critics. It argues, for example, that the necessary conditions of trust and empowerment in today's organizations are not possible with budgets still in place, because the entire system perpetuates central command and control." Innovation is vital for economic survival. But "budgeting stifles trust and empowerment, according to its critics, which in turn stifles innovation."
In a 2007 report, Dr. Peter Bunce, director of the BBRT, writes that startups and small and medium-sized businesses are initially very responsive to their markets because either the founder makes all the decisions or relies on a small group of highly-motivated managers. But as the business grows, the management team gets bigger, and often "flexibility and adaptability diminishes." "If SMEs follow this path already well trodden by larger companies they will end up in the same position of having a management model that fails to support innovation, flexibility and adaptability," he writes. They need to adapt a management model that allows them to manage through continuous planning cycles, make rolling forecasts, and manage costs through trends.
The BBRT is an element of The Player Group, a management advisory firm; the Round Table has 29 major corporate members. On its homepage, BBRT advocates a set of principles which include, among others, continuous planning and controls (rather than an annual budget process), resource allocation as needed (rather than based on annual allocations and plans), high performance standards (rather than detailed rules and budgets), and freedom of action by small front-line teams (rather than direct control of operations from the center).
The high costs of the budget process and its poor adaptability to stock market perceptions is another force working to bring about change in the budgetary process as it has been practiced over the last 50 years or so. An article in The Practical Accountant put the matter as follows, citing Herman Heyns of Accenture/Cranfield School of Management: "[T]the budget process is obsolete given today's economy, resulting in documents that are time-consuming to produce, of little predictive value, subject to gamesmanship and, quite frankly, out of date by the time they're implemented." Among the new approaches advocated by Heyns is the rolling budget. Under a rolling budget, performance of the operation over the last 12 months is evaluated on an on-going basis; projections for the next three months are generated every month.
Budgeting appears to be on the cusp of a change. How long it will take to transform itself is difficult to predict. In a new book titled Beyond Budgeting, Jeremy Hope and Robert Fraser start off by sketching the ambivalence felt by top and middle management toward formal, traditional budgeting. Then they go on: "Though this ambivalence toward budgeting has existed for decades, the balance of opinion has swung decidedly in favor of the 'very dissatisfied.' Even within the financial management community, nine of ten have expressed their dissatisfaction, finding the budgeting process too 'unreliable' and 'cumbersome."
The changes, as they evolve, will impact large corporations first and foremost. For the small business owner, budgeting in the traditional sense will continue to be a sensible, necessary, and valuable tool practiced, in essence, by examining current resources, eyeing the future, and making rational allocations for the immediate future.
Ackoff, R. L. A Concept of Corporate Planning. Wiley-Interscience, 1969.
Bunce, Dr. Peter, "Transforming Financial Planning in Small and Medium Sized Companies." Beyond Budgeting Round Table, 2007.
Drucker, Peter. "Planning for Uncertainty." Wall Street Journal. 22 July 1992.
Fearon, Craig. "The Budgeting Nightmare." CMA Management. May 2000.
Hope, Jeremy, Robin Fraser, Peter Bunce, and Franz Roosli. "Beyond Budgeting."Beyond Budgeting Round Table, 2009.
Klein, Karen E., "Better Business Through Budgeting," Business Week, Jan. 19, 2006.
Marginson, David and Stuart Ogden. "Budgeting and Innovation: Do budgets stifle creativity?" Financial Management (UK). April 2005.
Reason, Tim. "Building Better Budgets." CFO. December 2000. "Small Business Budgets and Budgeting", National Federation of Independent Business, 2009 "Throwing Out the Annual Budget." The Practical Accountant. February 2002.
Wuorio, Jeff, "8 Ways to Make a Budget Work," Microsoft Small Business Center, 2009 Copyright © 2009 Mansueto Ventures LLC. All rights reserved. Inc.com, 7 World Trade Center, New York, NY 10007-2195.